Posts Tagged ‘Student Loans’

On Monday, the Government Accountability Office (GAO) defended the current method for budgeting for federal lending programs, known as “credit reform.” By endorsing the status quo, GAO puts itself at odds with the Congressional Budget Office (CBO), which has championed a “fair value” alternative. The details are wonky but the stakes are big. Over a decade, federal lending support for mortgages, student loans, and the Export-Import Bank could appear $300 billion more costly under fair-value budgeting than under credit reform.

CBO is right to question the way we budget for these programs. But GAO is right that CBO’s version of fair value is the wrong solution. Instead, we need a new approach that captures the strengths of both ideas, while avoiding their flaws. I laid out that alternative in a recent report.

One reason we need a new approach is that credit reform violates fundamental principles of good budgeting, for reasons that have nothing to do with the fair value debate.

The problem

Credit reform uses present values to measure the budget impact of federal loans, recording any expected gains or losses the moment a loan is made. But the rest of the budget operates on a cash basis, recording the budget effects of tax and spending policies as they happen over time. These two approaches do not mix well together. By using present values, credit reform can make federal lending appear to mint money out of thin air. It also credits the budget today for earnings it won’t see until well beyond the official budget window.

Consider a simple example: the government lends $1,000 to a business for four years expecting a 4 percent annual return, or $40-a-year for a total of $160. To finance the loan, the government issues $1,000 in Treasury bonds that pay 1.5 percent interest. At $15 per year, interest costs total $60. Thus, the government would net $100.

How should we budget for those expected gains? One possibility would be to track cash flows, as we do for other government activities. The government lends $1,000 in year one, nets $25 in each of the four following years, and gets repaid $1,000 in year five. Its overall gain would be $100, just as it should be.

That gets the cash flows right, but the timing is ill-suited to budgeting. The upfront cost can make the loan look costly even though it actually brings in money. If Congress focused on a three-year budget window, for example, the loan would look like it costs $950 even though it actually earns $100 over its full life.

A poor solution

We can avoid that problem by eliminating the confusing lumpiness of the cash flows. Credit reform does so by calculating the net present value of the return on the loan, discounted using the government’s borrowing rate. That calculation (the second row in the table) shows an instant gain of $96 when the loan is made. (The $96 is slightly less than the $100 because of pesky technical details.)

Credit reform thus eliminates the lumpiness but at a big cost: it misleadingly claims the returns to lending happen instantly. In reality, those returns accumulate gradually over the life of the loan. In its zeal to get rid of the lumpiness bathwater, credit reform mistakenly throws out the timing baby. As a result, lending programs can look like a magic money machine.

Unlike tax increases or spending cuts, lending programs get instant credit for returns they won’t see for years, sometimes far beyond the official budget window. To take an extreme case, a 100-year loan on the above terms would score as almost $1,300 in immediate budget gains under credit reform, all before the government collects a dime in interest.

To the best of my knowledge, no other person, business, or organization budgets or accounts for loans this way (please share any counterexamples; Enron doesn’t count). Instead, they either accept the lumpiness of the cash flows or use an approach that avoids the lumpiness while reflecting the real timing of returns.

A better answer

It isn’t hard: Instead of tracking all the cash flows, we can report just the net returns on the loan. When the loan is first made, there aren’t any. In our example, the $1,000 loan exactly offsets $1,000 in borrowing to finance it. The reverse happens in year five when the loan gets paid off. In between, the government nets $25 each year: $40 in interest payments less $15 in annual financing costs.

Tracking net returns is a highly intuitive way to report the budget effects of making the loan. It would match the way we budget for tax and spending programs, and would respect the budget window.

The government can and sometimes does make money from its lending programs, but not instantly. The budget community should disavow the credit reform approach and recognize that earnings accumulate gradually over time. CBO, GAO, and budget wonks should join hands to fix this problem regardless of where they sit in the fair value debate.

Note: For more on the technical details, including how to deal with loan guarantees, how the fair value debate reappears in deciding how to measure net returns, and a second challenge in budgeting for lending programs, see my report and policy brief.

Lending programs create special challenges for federal budgeting. So special, in fact, that the Congressional Budget Office estimates their budget effects two different ways. According to official budget rules, taxpayers will earn more than $200 billion over the next decade from new student loans, mortgage guarantees, and the Export-Import Bank. According to an alternative that CBO favors, taxpayers will lose more than $100 billion.

Those competing estimates pose a $300 billion question: Which budgeting approach is best?

As I document in a new report and policy brief, the answer is neither one. Each approach tells only part of the story. Congress would be better served by a new approach that fairly reflects all the fiscal effects of lending.

Compared with what?

If lending programs perform as CBO expects, they will bring in new money that the government can use to reduce the deficit, increase spending, or cut taxes. In that sense, taxpayers may come out more than $200 billion ahead.

But these programs do not fully compensate taxpayers for their financial risk. If the government took the same risk by making loans and guarantees at fair market rates—perhaps by investing in publicly traded bonds—taxpayers would make much more. Taxpayers are subsidizing the students, homeowners, and companies that borrow through these programs. In that sense, taxpayers come out more than $100 billion behind.

The same issue can arise in personal life. Suppose your aunt asks for a $10,000 loan to start a business. You’ve got exactly that much in a government bond fund earning 2.5 percent, and she offers to pay 5 percent. She’s got a good head for business, so the risk of default is very low; realistically you expect a 4 percent annual return.

The loan sounds like a winner, right? Her 4 percent beats the bond fund’s 2.5 percent, if you can handle the risk. But there’s one other thing: your brother-in-law, equally good at business, would like a similar loan, and he’s willing to pay 6 percent, with an expected net of 5 percent.

Now the loan to your aunt sounds like a loser. Your brother-in-law’s 5 percent beats her 4 percent. You might still prefer to lend to her, but you would come out behind in financial terms.

The competing CBO estimates reflect this dichotomy. One approach compares the financial returns of lending with doing nothing (the $200 billion gain in CBO’s case, 4 percent versus 2.5 percent in yours). The other compares the returns with taking similar risks and being fully compensated (the $100 billion loss in CBO’s case, 4 percent versus 5 percent in yours).

Both comparisons provide useful information. If you want to predict the government’s future fiscal condition, you should compare the financial returns of lending with doing nothing. If you want to measure the subsidies given to borrowers, you should compare returns with the fair market alternative.

When you discuss your aunt’s proposal with your spouse, you would be wise to mention not only the potential financial gain (“4 percent is better than 2.5 percent”) but the subsidy to your aunt (“4 percent is less than the 5 percent your brother would pay”). Only then can you have an open discussion of your family’s financial priorities.

Today’s approaches

The same information is necessary for an open discussion of federal budgeting. But official budget rules, created by the Federal Credit Reform Act of 1990 (FCRA), require CBO to use just the first approach in its budget analyses. Official estimates thus measure the fiscal effects of lending, not the subsidies provided to borrowers. CBO rightly believes, however, that policy deliberations are incomplete without measuring the subsidies, which CBO calculates separately using an approach known as fair value.

Policy analysts have vigorously debated the pros and cons of FCRA and fair value for years. Neither side has scored a decisive win for a simple reason: both approaches are incomplete. Fair value measures subsidies well, but tells us nothing about fiscal effects; this is its missing-money problem. FCRA measures lifetime fiscal effects well, but tells us nothing about subsidies.

By recording expected fiscal gains the moment a loan is made, moreover, FCRA makes lending appear to be a magic money machine. Lending may pay off over time, but the gains do not happen the moment the loan’s ink is dry. Like any lender, the government must be patient to earn those returns. It must hold the loan, perhaps for many years, and bear the associated financial risk.

A better approach

For those reasons, I believe we should replace both approaches with a more accurate budgeting method, which I call expected returns. As the report and brief describe, the expected-returns approach forecasts the fiscal effects of a loan by projecting the government’s expected returns year by year, rather than collapsing them into a single value at the time the loan is made, as both FCRA and fair value do.

Expected returns accurately tracks the fiscal effects of lending over time, thus avoiding both fair value’s missing-money problem and FCRA’s magic-money-machine problem. It also provides a natural framework for reporting the fiscal effects of lending and the subsidies to borrowers. Expected returns would give policymakers and the public a more accurate assessment of federal lending than either of the approaches we use now.

When policy folks talk about America’s federal borrowing, their go-to measures are the public debt, currently $12 trillion, and its ratio to gross domestic product, which is approaching 75 percent. Those figures represent the debt that Treasury has sold into public capital markets, pays interest on, and will one day roll over or repay.

These debt measures are important, but they paint an incomplete picture of America’s fiscal health. They don’t account for the current level of interest rates, for example, or for the trajectory of future revenues and spending. A third limitation, the focus of this post, is that the public debt doesn’t give Treasury any credit for the many financial assets it owns.

As we noted last week, Uncle Sam has been borrowing not only to finance deficits but also to make student loans, build up cash, and buy other financial assets. That portfolio now stands at $1.1 trillion, equivalent to almost one-tenth of the public debt.

Those assets have real value. They pay interest and dividends and could be sold if Treasury ever cared to. In fact, Treasury has sold many financial assets in recent years, including mortgage-backed securities and equity stakes in TARP-backed companies, even as it expanded its portfolio of student loans.

One way to take account of these holdings is to subtract their value from the outstanding debt. The rationale is straightforward. If Ann and Bob each owe $30,000 in student loans and have no other debts, they both have the same gross debt. But that doesn’t mean their financial situations are the same. If Ann has $10,000 in the bank and Bob has only $5,000, then Ann is in a stronger position. Her net debt is $20,000, while Bob’s is $25,000.

The same logic applies to the federal government: $12 trillion in debt is easier to bear if the government has some offsetting financial assets than if it has none. That’s why both the Office of Management and Budget and the Congressional Budget Office regularly report the public debt net of financial assets. The net debt isn’t a perfect measure; many assets are harder to value than Ann and Bob’s bank accounts, and official valuations may not fully reflect their risk. Nonetheless, as CBO has said, the net public debt provides “a more comprehensive picture of the government’s financial condition and its overall impact on credit markets” than does the gross public debt.

The net debt is now a bit less than $11 trillion or about 68 percent of GDP. That’s more than $1 trillion less than the usual, gross measure of public debt, or about 7 percent of GDP. That difference was only 3 percent of GDP as recently as 2006. Under President Obama’s budget, it would expand to almost 10 percent by 2023, with financial assets growing twice as fast as the public debt.

Financial assets are thus playing a bigger role in America’s debt story. Accumulating deficits remain the prime driver of the debt. But the expansion of Uncle Sam’s investment portfolio means the growing public debt overstates America’s debt burden.

This post was coauthored by Hillel Kipnis, who in interning at the Urban Institute this summer.

The federal government has been borrowing rapidly to finance recent budget deficits. But that’s not the only reason it’s gone deeper into debt. Uncle Sam also borrows to issue loans, build up cash, and make other financial investments.

Those financial activities have accounted for an important part of government borrowing in recent years. Since October 2007, the public debt has increased by $6.9 trillion. Most went to finance deficits, but about $650 billion went to expand the government’s investment portfolio, including a big jump in student loans. Before the financial crisis, Uncle Sam held less than $500 billion in cash, bonds, mortgages, and other financial instruments. Today, that portfolio has more than doubled, exceeding $1.1 trillion:

Financial crisis firefighting drove much of the increase from 2008 through mid-2010. Treasury raised extra cash to deposit at the Federal Reserve; this Supplemental Financing Program (SFP) helped the Fed finance its lending efforts in the days before quantitative easing. Treasury placed Fannie Mae and Freddie Mac, the two mortgage giants, into conservatorship, receiving preferred stock in return; shortly thereafter, Treasury began to purchase debt and mortgage-backed securities (MBS) issued by Fannie, Freddie, and other government-sponsored enterprises (GSEs). And through the Troubled Asset Relief Program (TARP), Treasury made investments in banks, insurance companies, and automakers and helped support various lending programs.

Together with a few smaller programs, these financial crisis responses peaked at more than $600 billion. Since then, they have declined as Treasury sold off all its agency debt and MBS and most of its TARP investments and as quantitative easing, in which the Fed simply creates new bank reserves, eliminated the need for cash raised through the SFP.

Those declines have been more than offset by the government’s growing student loan portfolio. The federal government used to subsidize student borrowing not only by providing loans directly to students, but also by guaranteeing many private loans. In 2009, however, Congress eliminated private guarantees and dramatically expanded direct federal lending. The government’s portfolio of student loans has since increased from about $90 billion at the start of fiscal 2008 to more than $560 billion today.

As a result, the government’s financial investments now total about $1.1 trillion, essentially all of which was financed by borrowing. The debt supporting Uncle Sam’s investment portfolio thus accounts for almost 10 percent of the $11.9 trillion in public debt.

Source: The Federal Reserve Financial Accounts (formerly known as the Flow of Funds), Daily Treasury Statement, and the President’s Budgets. The figures here compare balances as of March 31, 2013 (most recent available) with balances as of September 30, 2007 (the end of fiscal 2007). We define financial investments to be all the federal government’s financial assets except for official reserve assets, trade receivables, and tax receivables; this definition approximates those used by the Office of Management and Budget and the Congressional Budget Office in certain debt calculations.

This post was coauthored by Hillel Kipnis, who in interning at the Urban Institute this summer.

Health care understandably dominated the headlines leading up to — and beyond — yesterday’s historic House vote. It’s important to remember, however, that the reconciliation legislation also includes major reforms in the way that the government supports student loans.

Under current law, federally supported loans are made both direct from the government and through private lenders. The government loans are direct loans (i.e., the government lends directly to students). The private loans are guaranteed by the government (i.e., private organizations lend to students and the government guarantees the lenders against the risk of default). The health/revenue/education legislation will eliminate the private lending channel. (The market for non-government private loans will continue to exist.)

Opponents have denounced this change as a government takeover of the student loan market. That makes for a great soundbite, but overlooks one key fact: the federal government took over this part of the student loan business a long time ago.

In a private lending market, you would expect lenders to make decisions about whom to lend to and what interest rates to charge. And in return, you would expect those lenders to bear the risks of borrowers defaulting. None of that happens in the market for guaranteed student loans. Instead, the federal government establishes who can qualify for these loans, what interest rates they will pay, and what interest rates the lenders will receive. And the government guarantees the lenders against almost all default risks.

In short, the government already controls all of the most important aspects of this part of the student loan business. The legislation just takes this a step further and cuts back on the role of private firms in the origination of these loans.

Yesterday, my students heard my second lecture on supply and demand. You know, the one in which we examined how government policies like rent control and the minimum wage can affect market outcomes. Those are important examples, and I dutifully discussed both of them. But I must admit they also feel a smidgen stale – how many millions of students have seen a lecture on rent control and the minimum wage?

To spice things up, I threw in a third example of government intervention: the market for guaranteed student loans. As I mentioned a few weeks ago, the government has a major program in which it provides guarantees for private student loans. Under the program, lenders are protected against the risk of future defaults by the student borrowers. In return for providing these loans, the lenders receive interest payments that are limited by a formula that is specified in law. (These payments are determined completely separately from the amounts that are charged to students which, for simplicity, I will ignore in what follows.)

This program is currently the focus of a major political battle: the Obama administration has proposed eliminating the program and replacing it with direct loans from the government (which currently account for a much smaller portion of the market). But I didn’t get into that larger debate in class. Instead, the reason I focused on this program is that it has experienced two crises in recent years:

In 2006 and 2007, the crisis was kickbacks. In their enthusiasm to win more business, private lenders were offering “inducements” to schools and student loan officers in order to get preferred access to students who wanted loans.

In 2008, the crisis was a lack of lending. In large part because of the financial crisis, private lenders had no enthusiasm whatsoever for making loans. As a result, there was a real risk that students might not be able to get loans.

As I told my students, I think both of these crises had the same root cause: the fact that the government, rather than market forces, determined how much lenders were paid for making guaranteed student loans. In both cases, the government got the payment levels wrong, and the crises followed soon thereafter.

Summary: President Obama and congressional Democrats have good reasons for wanting to eliminate federal guarantees for private student loans. They should keep in mind, however, that the resulting budget savings will likely be much smaller than official estimates suggest.

Health care and defense spending have grabbed most of the budget headlines lately, but they aren’t the only budget battles in Washington.

The latest tussle? Student loans.

The federal government supports college loans in two ways: by making loans directly to students and by guaranteeing loans made by private lenders. The current budget battle has arisen because President Obama and many congressional Democrats want to kill the guarantee program in favor of the direct program. Many Republicans, on the other hand, support private lenders, and thus want the guarantee program to continue.

There are three things you should know about this debate:

1. The guarantee program has experienced two crises in recent years. In 2007, the problem was kickbacks. Private lenders were being overpaid by the program, and some of them started competing for business by giving goodies to student loan officers. President Bush and Congress put an end to that by reducing payments to private lenders. Then the financial crisis hit, and we had the reverse problem: private lenders stopped lending. So President Bush and Congress stepped in with some duct tape and paperclips to keep the guaranteed loan market working. (Actually they gave private lenders a put option — the right to sell the loans back to the government — which many lenders used; in essence, the lenders got paid for originating loans, but didn’t hold them very long.)

In short, the guarantee program has been a headache for policymakers in recent years.

2. Guaranteed loans cost the government more than direct loans. There’s no law of nature that says that has to be the case. In principle, one can imagine a guarantee program that would cost less than direct loans. That could happen, for example, if the private sector is more efficient than the government in making the loans or if the private sector is willing to use student loans as a loss leader to promote other financial products (e.g., credit cards). In practice, however, the government has never been able to calibrate guarantees to the private lenders so that (a) lenders are willing to make the loans and (b) the guarantees cost less than direct loans.

When you put points 1 and 2 together, you can understand why many budget analysts and lawmakers want to kill the guarantee program and have the government make all the loans directly. That’s certainly the way that I am leaning. (If readers have any compelling arguments in favor of the guarantee program, however, I’m all ears.)

In fairness, though, opponents of the guarantee program should acknowledge one complication to their position:

3. Congressional budget procedures are biased in favor of direct student loans over guaranteed loans. As a result, the budget case against guaranteed loans is overstated. It isn’t wrong — we are still talking tens of billions of dollars over the next ten years — but it isn’t as strong as the official numbers suggest. One implication is that eliminating the guarantee program may not save as much money as lawmakers think. That’s important, particularly if lawmakers want to spend those savings on other programs.

This third point is the key to current budget brouhaha over student loans. To understand it fully, we need to delve into a bit of budget arcana.